“TO GIVE UP on equities, you have to give up on capitalism. To say that it’s no longer appropriate to invest in equities means you don’t believe that economies and earnings will grow.”
The closing words of the mid-July presentation by John Ross linger after the presenter has slipped next door for some well-earned lunch. These are not the views of a financial doom-monger, after all. This is a portfolio strategist at Fidelity, the world’s largest mutual fund manager.
Ross has just given a compelling analysis of why equity markets might or might not be about to pull out of their 30-month nosedive. His talk – entitled “Has the bear growled enough?” – is nicely balanced.
He reviews the evidence of a century of stock market ups and downs, presents all kinds of reasons why markets could be seen as either oversold or undersold but ultimately comes down on the side of a generation-old truism: over time, nothing beats equity investment.
That’s fair enough, if a little predictable. But it is the parting shot that strikes an unsettling note. With major stock markets well on their way to a third successive year of negative returns – a state of affairs unknown since the 19th century – people are starting to think the unthinkable.
What are the implications of this colossal crisis in confidence that has struck the business and financial world? How can trust be restored to a system that – for all the protestations of Bush, O’Neill, Greenspan and others – is severely battered, if not broken?
What kind of returns should investors expect in this changed world? And how on earth do they go about achieving them?
Or, to turn Ross’s comment around, if investors have lost faith – for the time being, at least – in equities, in growth and (perhaps) in aspects of capitalism itself, what does that mean for financial markets and money management in the future?
There’s one thing everybody is sure about. This is the sort of bear market that nobody in today’s financial world has ever experienced. According to Henry Kaufman, you would have to have been around in 1929 and the early 1930s to have seen anything even remotely comparable.
“There is no post-World War II parallel for what is going on at the moment,” says Kaufman, the legendary former head of research at Salomon Brothers who is now chairman of his own investment consulting company.
The bears hold forth
From investment analysts and bankers to CFOs and CEOs, the whole financial and corporate world is under a cloud. Credibility has been destroyed. So has wealth, on a scale without precedent in recent times.
Market volatility is making it extremely difficult for money managers and traders to operate. And the equity-marketing engine that drove Wall Street’s dizzying expansion – and that of all western markets – over the past 20 years has shuddered to a halt.
Bears such as Andrew Smithers – chairman of London-based investment consultancy Smithers&Co, whose analysis is widely followed by investors – reckon the US stock market still has about 30% to fall before it reaches fair value.
Barton Biggs, the investment and strategy chief at Morgan Stanley Investment Management, believes the Dow Jones could fall through 4500 – half its current level of just under 9000.
Some think the market’s plunge has only just begun. David Tice, manager of the US-based Prudent Bear Fund – the best-performing domestic mutual fund this year, with a return of some 60% – predicts the Dow will fall below 3000, with the Nasdaq and S&P500 indices bottoming out in the 400 to 500 range.
The next shoe to drop, say the bears, will be in the real estate market – which is already showing classic bubble signs, both in the US and in the UK, and especially on the residential side.
And with excessively leveraged US consumers having lost their shirts in both equities and real estate, the floor will then drop out of the global economy – triggering a recession that can only be compared to that of 1929 to 1932.
Such pessimism may be excessive. But there is no doubting the fact that investor psychology has turned on its head with, as in previous crashes, extreme gloom replacing earlier euphoria. And it is the nature of financial markets, after all, to overshoot as much on the downside as up on the upside.
“At the end of a very inflationary 1970s, everyone decided that equity was the best hedge against inflation,” says Alan Brown, group chief investment officer and vice-chairman of State Street Global Advisors – the world’s largest institutional money manager, with over $700 billion of funds under management.
“We then rode a 20-year bull market and made the egregious mistake of thinking that it was our own skill rather than luck.”
At the end of July, it looked as if the equity markets were in the grip of outright capitulation. US equity mutual funds redeemed a staggering $70 billion from the market in June and July as prices lurched down alarmingly.
Rumours of forced selling in the US and Europe from insurance companies were rife – with huge losses on investment portfolios starting to cause serious capital problems in some cases and widespread worries over solvency ratios.
Dedicated short sellers – mainly the hedge funds, but also investment banks and institutional investors that are able to follow this strategy – were making hay. And there were no buyers in sight, except for the short sellers buying to cover their short positions.
Was that the sign, as many analysts and investors like to think, that the three-year bear market is nearing its end? Was it proof of the continuing fragility of markets, which just as many investors and analysts feel have a good deal further to fall?
Or was it the start of an exodus out of equities – primarily by the US retail investor who has done so much to prolong the bull market and prop up the global economy – into other asset classes such as fixed income, real estate, commodities and cash?
With some $2 trillion sitting in US money-market funds alone, there is plenty of liquidity ready to return to equity markets. And markets have rallied since July – although some say it is just the calm before a new selling storm in the autumn.
“What we saw in July was almost a world panic,” says Nils Taube, the renowned London-based investor who has been managing his and other people’s money for almost 40 years – latterly as chairman of Taube Hodson Stonex Partners.
But Taube believes that people trumpeting the death of the equity culture are talking rubbish. “We saw this before – in 1974, when everyone was saying this is the end of the equity markets and you should only buy things like krugerrands and baked beans,” he says.
“The people who did that got into trouble, while the people who stuck with equities did very well.” He adds: “I don’t trust any sentiments which are uttered at a time when markets have fallen so much.”
The 74-year-old Taube is famed for his contrarian approach, a refusal to follow fashions. Recently up to 25% of the firm’s £3.5 billion funds under management has been in cash, but it is starting to put money back into equities again.
“I wouldn’t like to forecast the bottom and how much further markets might fall,” he says. “But I would predict that the timing of the bottom is about is about three to four months away. We are getting ready to invest a little money.”
As far as Taube is concerned, the only asset classes worth having money in are equities and cash. Like many people, he believes that real estate is another bubble ready to blow. And he believes that government bonds offer extremely poor value.
“I’m very suspicious of long government bonds yielding around 4.5% when money is being pumped into the economy and there is bound to be some kind of inflationary effect,” he says. “I’d rather have money in the bank than in bonds.”
But many other people believe that the extent of the bear market has triggered a structural and generational shift. After almost three years of negative returns, these people argue, investors are questioning the whole rationale of equity investment.
“These shifts take a long time to occur,” says Marc Faber, managing director of Asia-based Marc Faber Limited and editor of the Gloom, Boom and Doom Report. “People didn’t give up on equities immediately after 1929, or Japan immediately after 1989. It took a while.” He adds: “There is still a latent bullishness towards equities even after the Nasdaq has fallen by more than 70% from its high.”
But Faber believes that the shift is already under way. “In the same way as 1989 was a milestone high for Japan, 2000 was a milestone high for the markets of the western industrial countries,” he says.
“People were brainwashed into equity and the experience of the 1981 to 2000 bull market, where every correction led to another bull market, means that it will take a long time before people say: ‘equity, never again’.”
But, he adds: “2000 was the beginning of a major change in leadership – to asset classes other than equities, or at least US hi-tech equities. My bet is that leadership in the next 10 years will be in real assets like commodities and gold, and, in terms of equities, probably a shift into Asia from the US.”
Quite apart from fears about equity valuations, corporate earnings and economic growth, the markets seem to be suffering a deeper malaise. Whether this reflects geopolitical uncertainty about the possible US war with Iraq, or concern about an anti-globalization backlash, or any number of potentially destabilizing influences around the world, is difficult to judge.
The stakes are enormous
But there is certainly a recognition that the excesses of the bubble years require a big clean-up in the corporate and financial world that has only just begun, and that major structural changes may be needed to restore confidence in free markets.
Analysts and bankers are seen as snake-oil salesmen. CFOs and CEOs are viewed as guilty until proven innocent. And many money managers seem like simpletons who were still chanting the “equity is best” mantra as they were walking over the edge of the cliff.
“These are wild days,” says Hans-Joerg Rudloff, chairman of Barclays Capital. “We’ve always had crashes, excitements, monetary crises, but nothing in this form. What is at stake is our entire economic and financial model, which seems to serve only the few at the expense of the many.”
He adds: “If we don’t eliminate the excesses, the system will suffer. And if the process of deregulation, privatization and free markets gets turned back, the effect on financial asset prices will be dramatic.”
Protectionism and nationalism are already starting to reappear. The Bush administration has already shown its protectionist colours, raising steel tariffs and threatening to do the same for the equally hard-pressed textiles industry.
In the wake of September 11 it is clear that ‘”America first” is the motto that is driving economic policy every bit as much as international policy. It is equally clear that in economic management as much as world policy many people outside the US (and, increasingly, inside) fear the administration does not know what it is doing.
The retreat from globalization is also evident in emerging markets. The move in South Africa to make drug companies distribute anti-Aids drugs for free, or Brazil’s refusal to accept patent protection for drug companies, are just two signs of a growing resentment against globalization.
“Any attempt to restrict international money and capital flows could lead to a huge recession,” says Rudloff. “We will have to fight it but we have severely weakened our case. Free markets have not been seen to work in terms of benefiting people at all levels.”
He adds: “We have been through a period where greed overcame all feelings of responsibility and we will need all our strengths to defend what has been achieved. It should not be necessary, but the behaviour of bankers, industrialists and local oligarchies has been so excessive that the defence has been weakened.”
Rudloff argues that what is needed is “a time of restoration”. He says: “We need to restore olds values, old systems, old ways of doing things, with a heavier hand from government. Either we change our own ways of doing things or it will be forced on us. The time of the unchallenged superiority of our system is over.”
To hear a former head of Credit Suisse First Boston – a firm synonymous with the promotion and exploitation of international capital flows and unbridled free markets – say such things is to underline the challenge facing the system.
In recent weeks both Citigroup chairman Sandy Weill and (belatedly) JPMorgan Chase CEO Bill Harrison have shown signs of contrition, perhaps fearing that failure to confront the sins of the past could leave their vast financial empires vulnerable to a regulatory, Glass-Steagall-style break-up.
One former investment banker predicts that firms might be forced to separate their research and mergers&acquisitions advisory divisions – and perhaps other divisions too – into stand-alone companies, with legally binding Chinese walls that keep them apart from their other activities.
What is clear is that the clean-up has a long way to go, both in the financial and corporate worlds. Handcuffing a few corporate miscreants is a symbolic start. Forcing chairmen and CEOs to sign oaths certifying financial statements is another.
But real change in corporate behaviour might only be possible if and when company leaders believe that adhering to high ethical standards makes their companies more attractive to investors.
That, in turn, will require investors to believe that ethical companies make for better long-term investments than those with high, artificially boosted earnings. After all it was the thirst for earnings growth that encouraged most of the excesses. Investors must take their share of blame for encouraging the culture of greed over responsibility.
“There is no leadership at the moment,” says a former CEO. “People must be prepared to stand before the population and say ‘huge errors were made and huge excesses and I can categorically state that they will never be tolerated in this organization again’.”
He adds: “The leadership must come from the big company chairmen and CEOs, who must restore ethics to business and set standards that everyone adheres to.”
Coca-Cola’s decision to treat stock options as an expense has been viewed as one sign of this new climate of corporate responsibility. As one analyst points out, though: “It’s easy for them to do because it doesn’t hurt them. It only means a few cents per share’.”
The likes of Berkshire Hathaway chairman Warren Buffett are trying to use their influence to good effect. But, for the most part, companies – particularly in the most heavily affected sectors such as technology – give the impression of trying to lie low and wait for the storm to pass.
“Companies don’t get it,” says an analyst. “They are spending most of their time trying to figure out how they can give themselves huge stock option programmes at these lower levels and expense them at the same time.”
For all investors, institutional and individual, taking a view on the future direction of equity prices would be difficult enough even without suspicions about the quality of corporate earnings that have arisen in the wake of Enron, WorldCom and the rest.
In an article in July entitled Time to Buy or Time to Bail Out? Brown at State Street estimated that at least 20% of corporate earnings could be wiped out by more conservative accounting. Smithers&Co reckons that accounting for stock options alone could wipe out more than 15% of the earnings of S&P500 companies.
In the thrall of past assumptions
The combination of falling markets, illusory corporate earnings and lack of investment alternatives would pose enough of a problem if investors were using modest return assumptions.
But they aren’t. Using what Buffett calls the “rear-view mirror” psychology that guides investors, most pension funds are using assumptions based on what has happened in the past few years.
So the average assumption for pension funds at the moment is 9.5% – which would seem a trifle optimistic at a time when bonds are yielding 5% and US large-cap equities, over the past 30 months, have produced an inflation-adjusted return of minus 11%.
Buffett’s thoughts on the stock market were most recently outlined in a presentation in May to New York investment bank Allen&Company, to which the Oracle of Omaha is close.
He pointed out that in the 20th century, there were 44 years of bull markets – concentrated in three powerful runs – and 56 years of stagnating markets, in which the US economy grew and yet the stock market index lost value or moved sideways.
The lack of correlation between economic growth and stock market performance is striking (see chart on page 52). Between 1964 and 1981, for instance, the Dow Jones Industrial Average gained just 0.01%. Over the next 17 years, a period in which US GNP growth was less than half that of the preceding 17 years, the Dow rose by more than 1,200%.
Similar phenomena were observed in the 1920s and the 1950s. Despite explosive economic growth in the first 20 years of the century, the Dow rose from just 66 points on January 1 1900 to 71 points on December 31 1920. It then took off, rising 430% before peaking in September 1929.
Nineteen years later, the Dow was still trading at less than half the 381 level it reached before the crash, despite the fact that the 1940s generated by far the largest gain in per capita GDP of any decade in the century.
Over the next 17 years, the stock market rose five-fold, before sinking into its 17-year stretch of stagnation between 1964 and 1981 – a period which, of course, contained the most savage bear market of recent times in 1974/75.
Buffett points to investor psychology as the only explanation for this. In the first 20 years of the century, he says, stocks were regarded as riskier investments than bonds – as they still are today – but therefore (and this is the difference) deserving of a higher yield to compensate investors. That automatically capped their potential for capital appreciation.
In the hangover after the 1929 crash, retail investors were transfixed by the frightening market of the early 1930s – in which the Dow lost 89% of its value between 1929 and 1932 – and became entirely averse to the idea of owning equities.
Buffett points out that it is not just the individual investors that are driven by rear-view mirror psychology. Institutional investors are equally at fault – how could one otherwise explain their tendency to reduce their holdings of equity when prices fall?
Surely, if investors felt that the equities they own were worth buying when the markets were higher, they could only conclude that they offered even greater value once markets had fallen?
The same is true for assumed returns. Buffett points out that in 1975 four of the largest US companies held to extremely modest expectations for their pension plans – Exxon at 7%, General Motors and General Electric at 6%, and IBM at below 5% – despite the fact that risk-free government bonds were yielding 8% at that time.
Go forward to 2000, with long-term government bonds yielding just over 5%, and those same four companies were using assumptions of between 9.5% and 10%.
“I’m a sporting type, and I would like to make a large bet with the chief financial officer of any one of those four companies, or with their actuaries or auditors, that over the next 15 years they will not average the rates they’ve postulated,” said Buffett.
General Motors’ recent announcement that it was putting an additional $3 billion into its underfunded pension plan suggests that Buffett’s money is as good as in the bank already.
Most pension plan assumptions have been made with the enormous returns of the late 1990s fresh in the memory, rather than on the basis of the long-term performance of equities.
“When markets are booming, people have lunatic expectations,” says Smithers. “When returns go up, they expect even higher returns. That’s the way of it. You have a complete disconnect between reality and expectation. But now expectation is coming back down towards reality – and will probably overshoot again.”
According to Buffett and other luminaries such as Morgan Stanley’s Biggs, a more realistic assumption would be in the 6.5% to 7% range. As Buffett says: “Not bad at all – that is, unless you are still deriving your expectations from the 1990s.”
But even returns of 5% might be difficult to achieve in the current environment. “We’ve seen major, major excesses in terms of valuation,” says Faber. “If an investor bought the S&P index now, at a level between 800 and 900 points, they are still not necessarily getting a bargain. It could easily remain there for the next few years.”
Even though the S&P500 has fallen by over 40% from its 2000 peak – and the Nasdaq by almost 75% – valuations are not exactly at bargain levels. The price-earnings ratio of the S&P index is still just under 40 – compared with 20 in late 1996, when Greenspan made his famous “irrational exuberance” speech and when the index stood at 750.
“If you look at past bear markets, the P/E ratios at the bottom have generally been much lower than they are now,” says Ross at Fidelity. “But in the past you have had much higher interest rates and, in general, the lower the level of interest rates, the higher the P/E.”
However, Ross concedes that the fact that the P/E ratio on the S&P index is still above its five-year average is “not great news”. He says: “You can’t say that markets are cheap at the moment on a valuation basis.”
Brown at State Street argues that the excesses of the bubble could be worked off without a further collapse in markets. A prolonged sideways movement could clearly be one way, such as those earlier in the century.
“With returns from equities now likely to be much closer to those of bonds, but with much higher volatility, investors of all types will want to reconsider their asset allocations and their weighting to equities,” he says. “Fewer investors will be happy to accept an unadulterated roller-coaster ride from equities, and asset allocations are likely to become more balanced.”
Craig Gillespie, head of asset allocation at UK actuaries and pension plan consultants Watson Wyatt, says a shift from equities to fixed income among UK pension funds has already been visible in recent years.
In the early 1990s, he says, equity investment peaked at around 82.5% of the assets of UK pension funds. It is now down to around 73% (or even lower, at 66%, in the case of funds with more than £500 million of assets).
The chief beneficiary, among other asset classes, has been fixed income – some 17% of assets – while the larger funds have also increased their weightings of index-linked securities and property.
Hedge funds and other less conventional investments are likely to be the other beneficiaries of this shift in asset allocation, with Gillespie predicting that over the next five years the proportion of larger funds’ assets invested in equities could fall below 60%.
But as Morgan Stanley’s Biggs recently pointed out, it is not easy for large pension funds and other institutional investors to shift between asset classes because the sums involved are so enormous. “We believe funds should go to a more aggressive, unconventional strategic policy allocation,” he recently wrote. “But that is easier said than done because almost by definition unconventional means less liquid and more volatile.”
He adds: “For large funds, it is difficult to achieve meaningful participation in non-traditional asset classes like hedge funds and commercial real estate. And how much of a $50 billion fund can you have invested in high-yield and emerging-market equities?”
With institutional investors reducing their equity holdings, and individual investors (certainly those who bought in 2000 or just before) unlikely to consider returning to the stock market in the near future, the demand/supply picture does not look rosy.
Highly leveraged companies on both sides of the Atlantic will soon face no alternative but to issue new equity to keep their finances afloat. Even at rock-bottom prices, it may be difficult to find buyers – and the overhang of equity supply is likely to exercise further downward pressure on markets for the foreseeable future.
But it is hard to see where else investors can go even if they do downsize their mainstream equity allocations. Government bonds are poor value – although such index-linked securities as TIPS (Treasury inflation-protected securities) in the US and French government index-linked bonds have been producing high returns in recent months.
Corporate bonds are performing badly (with defaults and downgrades still rising, and spreads continuing to widen). Real-estate valuations look toppy. Commodity prices have not shown much upwards momentum and are unlikely to do so until there are clear inflationary signs. Emerging markets offer good value but poor liquidity and high volatility. And cash rates are dismal.
What investors must do, commentators increasingly believe, is to free themselves from the curse of indexation. Benchmarking themselves to indices on the way up meant they had to own stocks that they knew were overvalued just to keep their weightings in line.
On the way down, benchmarking almost guarantees them making negative returns. It also provides the questionable pleasure of having to pay a money manager just because he or she has performed marginally less abysmally than the index.
Hedge funds, which operate on a total-return basis, should benefit from a switch from passive to active management. But, to make money in markets that are either going sideways or down, investors will have to be more active altogether – either relying on stock-picking, especially of small to mid-cap stocks, or adopting a more trading-oriented strategy.
A trader’s market
“This is a stock-picking environment,” says Ross at Fidelity. “In today’s market, active management is the right approach. Investors shouldn’t look at the market as some kind of tracking index. It is possible to pick stocks that are going up.”
In the UK, Ross points out, almost 40 of the FTSE 100 stocks had shown positive returns between the start of 2000 (the peak of the bull market) and the middle of July this year – compared with a 42% fall in the index over the corresponding period. Half of those stocks have risen by more than 25%.
Trading volatility – as practised to hugely profitable effect (most of the time, at least) by hedge funds and investment banks – is another option. So is making greater use of existing portfolios, through writing options on equity holdings or lending stock to short sellers.
If and when stock markets establish new trading ranges, investors might have to get used to earning money by trading those ranges. Again, this is nothing new. In the 17-year period of stagnation between the mid-1960s and the early 1980s, many investors made decent returns by buying when the Dow touched 800 and selling when it hit 1000 – a range it traversed more than six times during that period.
But what is certain is that investors will have to reconsider the buy-and-hold doctrine that has driven equity investment for at least a generation. “People will have to start trading more,” says Faber. “The buy-and-hold strategy can work for a number of years, but not for ever.”
Apart from that, there is the question of market timing. “The idea that equity always pays off is wrong,” says Barclays Capital’s Rudloff. “The problem is that the entry point is the absolutely determining factor. If you bought in 2000, you might have to wait 20 or 30 years before you see any kind of appreciation.”
Scarred for life
Just as the inflation of the 1970s scarred the mindset of a generation of investors, bankers and industrialists – convincing them that equity was the only long-term investment – it is quite possible that another generation is emerging with a profoundly different view.
For these people, their experience of the wealth destruction of recent years might be so traumatic as to deter them from equity investment altogether, as happened after the 1929 crash.
To the latent bulls – and there are a good many of these about – this is music to the ears. “From a contrarian point of view, it’s very good news when you start hearing people saying that equity investment is dead,” says Ross at Fidelity. “That means that pretty much all the bad news is reflected in prices.”
If July did indeed mark the capitulation that is always observed before bear markets bottom, there may be little to worry about. But investors may still have to remember one simple maxim, as propounded by Taube: “You don’t buy indices, you buy companies.”
To investors of the stature of Buffett and Taube, whose track records speak for themselves, investing in equities is a matter of adhering to simple principles, doing your homework and being patient.
But even they have never had to contend with what is happening in world markets right now. To have the wealth destruction of the past two years on its own would have been a traumatic event.
But to pour on top of that the evidence of cronyism, fraud, greed and excess from the corporate and financial worlds is to invite a loss of trust that will not be easily regained.
A fool and his money may be easily parted. But when that fool is allowed to feel that his money was cheated from him, he is unlikely to return to the investment gaming table in a hurry.
Even Alan Greenspan, who still believes (against the weight of history in the past century) that economic recovery would be the basis for another prolonged market rally, referred in his July testimony to the Senate banking committee to a “once in a generation frenzy of speculation”.
Henry Kaufman, who had a ringside seat for the bulk of the bull market at Salomon Brothers and has spent some 40 years on Wall Street, says it will take “a while” to reignite what he calls the “speculative juices” in the market.
And those who see parallels to 1929 and its aftermath see signs that the Bush administration may already be repeating the mistakes of Herbert Hoover’s administration after the Great Crash.
Protectionism is already active policy. Attempts by administration officials – from Bush down – to talk up the market are having precisely the opposite effect. The hunt is on for scapegoats.
New legislation is being lined up to curb corporate and financial excesses. And the political response to the collapse in confidence is only just beginning.
In his July testimony, Greenspan talked of “strengthening the legal base of free-market capitalism”. Who knows, at this stage, what form that could take?
It may well involve the reintroduction of measures introduced after the 1929 crash – such as the Glass-Steagall Act. It will certainly involve making CEOs – whose pay levels have recently been almost 400 times the salary of the average US worker – more directly responsible for their businesses.
It may well involve investment banks taking far greater responsibility (not just moral but legal) for their activities – whether in underwriting IPOs, analyzing stocks or managing the inherent conflicts of interest between their client dealings and their proprietary trading – than they would like.
It will certainly involve advocates of deregulated free markets having to argue much more coherently for the benefits of their system in the light of the systematic excesses that have been tolerated and encouraged.
While it goes without saying that the fear that is stalking the markets will eventually turn to greed again and depression back to euphoria, nobody can predict – as ever – when that might be.
It could be next week. It could be in 20 years’ time. The markets may have bottomed already. They may have a further 50% to fall. In the long run, markets are all about valuation. In the short run, they are all about psychology.
The stakes are enormous. As every day goes by it looks more likely that the pendulum is swinging back against unfettered free markets – and at least possible that a backlash could be starting that might wreak such havoc on financial assets as to make the last 30 months seem like a picnic.
Greenspan recognizes this risk. “The system is frayed, but it is not broken,” he told the US Senate in July. “Beneath all the problems is a very sound structure. If we try to change the system in a fundamental way, we may do more damage than help.”
The challenge to the capitalist system is real. This may be the beginning of the end of the bear market. But it may also be the beginning of the end of the free-market world as we have come to know it.
From hero to zero
Even Federal Reserve chairman Alan Greenspan, who is now getting as much blame for causing the crash as he won plaudits for prolonging the bubble, seems confused.
| Alan Greenspan | ||||||
Economic recovery is encouraging, he assured the US Senate banking committee in July. So why isn’t the stock market responding more convincingly?
In the minds of many commentators, part of the answer is easy to come by. It’s because the Fed has lost its way: and has no coherent strategy for post-bubble economic management.
“The Fed has been woefully incompetent in not recognizing the asset bubble, and then not doing anything about it,” says Andrew Smithers, chairman of investment consultancy Smithers&Co.
“Greenspan started to do something about it, saw it was unpopular and then decided to do nothing. It is bad enough not to restrain an asset bubble. But to egg it on and act as cheerleader is criminal.”
Smithers, who describes Greenspan as “the greatest creator of financial instability since Japan” after its crash in 1989/1990, puts it simply. “The job of central banks is not to be popular,” he says.
That may be a touch unfair. Greenspan’s warning about “irrational exuberance”, after all, was issued in late 1996 when the Dow Jones index was over 30% lower than it is now. It would also be harsh to overlook his equally stark warnings that the vast majority of internet companies would go bust.
But whenever people lose money a culprit has to be found. And the critics of Greenspan and US monetary policy have a point.
By pumping liquidity into the financial system at every available opportunity, by bailing out financial markets whenever they looked to be under threat, and by trumpeting the US productivity miracle that led investors to believe in the new economy paradigm, Greenspan and the Fed stand accused of fuelling the bubble.
“People are starting to realize that the whole US productivity miracle has been hogwash,” says Marc Faber, managing director of Marc Faber Limited. “If it’s as great as Greenspan suggests, then why are the trade and current account deficits so large?”
Critics assert that the productivity miracle was as much of a chimera as the new paradigm. Instead, they allege, what the Fed aided and abetted was a credit bubble that is starting to explode.
What is giving cause for concern is that the Fed’s instinct is still to keep cutting interest rates – believing that it can still save the markets and the economy as it did after the stock market crash of 1987, the US banking crisis of 1990, Mexico’s liquidity crunch in 1994, Asia’s meltdown in 1996, Russia’s default in 1998, or the collapse of Long-Term Capital Management in the same year.
“The Greenspan policy response has been that if you have a problem you ease. If that doesn’t work, you ease some more,” says Faber. “All that happens is that you create one bubble on top of another.”
The bears’ case is this: by encouraging the vast leveraging of the US economy – not just in the financial system, which has grown by 100 times in the past 10 years (mainly through the explosion in derivatives), but throughout the heavily indebted corporate and household sectors – the Fed has helped to create systemic risk.
